Monetary-fiscal policy interactions when price stability occasionally takes a back seat
Can a central bank occasionally subordinate its price stability objective to the goal of fiscal sustainability without jeopardizing price stability more generally? This paper suggests that the answer is no. I build a model with a fiscal authority that is limited in its willingness or ability to raise primary surpluses and a central bank that accommodates its interest-rate policy to the fiscal conditions. The model generates endogenous shifts between an orthodox and a fiscally-dominant policy regime. The risk of future regime shifts has encompassing effects on equilibrium. Inflation is systematically higher than it would be if fiscal policy always adjusted its primary surplus sufficiently and monetary policy was solely concerned with price stability.